FHA's mortgage troubles build

Agency works with borrowers to offset default rise

SAN FRANCISCO (CBS.MW) -- Foreclosures are at a record in the United States and the government agency charged with promoting homeownership is finding itself with a growing portfolio of bad loans.

About 4.7 percent of Federal Housing Administration borrowers are at least 90 days late on their loan payments, nearly twice the default rate of 1995, the agency says.

Last week, the Mortgage Bankers Association, which tracks mortgage trends through its member lenders, put FHA's rate even higher -- at almost one in eight.

The FHA, however, points out that the MBA wraps shorter 30-day delinquencies into its count, many of which pose much less risk of foreclosure.

However the numbers are crunched, one thing is clear: As the U.S. economy remains weak, the FHA's loan program is facing a stress test, housing experts said.

Market changes such as increased competition in alternative mortgages from the private sector, automated underwriting that identifies high-risk borrowers and a wave of refinancing has left FHA with a pool of less creditworthy borrowers than in the past, MBA chief economist Doug Duncan said.

"You have these three forces acting to pull the best borrowers out of the FHA pool so the remainder are higher-risk borrowers," he said. "There's a greater probability on average that those borrowers will go on to be delinquent or foreclose."

Many borrowers who would have had to turn to the FHA 10 years ago are now finding suitable loans in the private sector, he said.

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In a strong economy where jobs are abundant, the FHA's steadily rising default rate wouldn't necessarily be cause for concern, particularly since the agency claims the increase hasn't translated into higher foreclosure rates.

But set against a backdrop of higher unemployment and a rising number of people losing their houses altogether, the figures are more worrisome.

About 1.23 percent of all U.S. mortgages were somewhere in the foreclosure process during April, May and June, the MBA said. That's the highest rate since the group began tracking the data in 1972. The previous record for loans in the foreclosure process was 1.14 percent in the first quarter of 1999.

FHA and Veterans Administration loans comprised a disproportionate share of the most current foreclosures, according to the MBA. The percentage of FHA-backed loans in foreclosure jumped 47 basis points to 2.79 percent while VA loans' foreclosure rate hit 1.72 percent, an increase of 31 basis points.

But foreclosure among conventional loans is rising at a much slower pace. The percentage of private sector loans in foreclosure edged up 6 basis points to 0.87 percent in the second quarter, the MBA said.

The FHA, however, says the numbers aren't as bad as the MBA reports. It said it acquires about 1 percent of its portfolio through foreclosure every year -- year to date, 2002 is holding near to that standard at 1.10 percent.

The FHA maintains its data is more complete because it's based on mandatory feedback from 100 percent of lenders compared with MBA's voluntary survey of about 60 percent of its members.

Social engineering at a crossroads

Defenders of the FHA loan program say it is by definition a riskier entity, though it isn't in the subprime lending business that's accused of exploiting the poor through predatory loans.

"It's meant to provide loans that private-sector conventional lenders aren't comfortable making without added insurance protection," said William Apgar, a senior scholar at Harvard's Joint Center for Housing Studies and former FHA commissioner.

Designed to expand homeownership to those who would otherwise not be able to afford it, FHA loans allow many low- and moderate-income consumers to buy houses with a down payment of as little as 3 percent. Private-sector mortgages typically require 10 to 20 percent down, although there are many conventional loans available with just 5 percent down.

Indeed, the FHA, along with mortgage innovations in the private sector, has succeeded in boosting the U.S. homeownership rate to a record 68 percent last year. Nearly eight in 10 FHA borrowers are first-time homebuyers, and 40 percent are minorities.

What's more, many FHA borrowers simply underestimate the other expenses involved in being a homeowner, said Tammie X. Simmons, an assistant finance professor at Lehigh University.

"When times get tough, the FHA borrowers don't have the resources to draw upon to continue to make those payments."

Despite rising defaults, many 30-day delinquencies are considered minor and are often resolved without foreclosure because FHA-mandated loss mitigation efforts kick in around 90-day tardiness, Apgar said.

"Increasingly, folks, as they scramble to pay their bills, understand there's no major consequence to being 30 days late. So they put off paying that bill to pay another bill."

Loss mitigation keeps handle on foreclosure

Still, the growing use of loss mitigation methods that restructure or extend the period of the loan is proving effective, said Randall Johnson, chief executive of Market St. Mortgage in Clearwater, Fla. About a third of the $2.5 billion in loans the company originated are FHA loans.

"You do have some inexperienced borrowers," Johnson said. "Credit counseling as they're getting their loans has really helped improve the performance."

Market St. Mortgage has seen its default rate cut in half since requiring counseling at branches with high default rates two years ago, he said.

"It's important for borrowers to know they can do this because if it gets too far down the line and gets into foreclosure, then it gets too late to work through loss mitigation programs available to consumers."

FHA loss mitigation techniques now include:

Preforeclosure sale -- less popular now that the focus has shifted to keeping people in their homes.

Special forbearance for those who qualify for a long-term payment plan.

Loan modification that could allow capitalizing delinquent payments or reamortizing the loan.

Permanent change to loan terms to try to match a borrower's ability to pay.

Deed in lieu of foreclosure for those who can't afford the debt. Exchanging the deed for debt forgiveness is often a last resort because it leaves a blot on a borrower's credit, though it is less damaging than full foreclosure. So far this year, the FHA has processed 466 deeds in lieu of foreclosure compared with 70,000 full foreclosures.

Battling fraud

Another problem that continues to plague FHA is the presence of unscrupulous lenders and appraisers who prey on the inexperience of borrowers, said Lisa Donner, director of the financial justice center at low-income-housing advocacy group ACORN.

"A problem intrinsic to making loans available to low-income folks is fraud and people not taking responsibility for these loans," she said.

Among the biggest concerns is "property flipping," where investors buy houses for little money, do some repairs and sell them at inflated values, she said.

"In Baltimore, over the years there's been a huge abuse of the FHA program where people are being put in houses that are being appraised for much more than they're worth and where the broker/investor is wildly inflating people's income."

But the FHA has been boosting its internal controls to try to get a handle on markets like Baltimore that are rife with abuse, Apgar said. "While fraud has its role, it would be erroneous to conclude that it's enough to be a risk to the fund. It's just not at that level."

The Federal Housing Administration is funded through the mortgage-insurance premiums charged to borrowers and not by taxpayer dollars, though it's a division of the U.S. Department of Housing and Urban Development.

The ultimate test for the FHA loan program is how adaptable it proves to be, Duncan said.

"They're still insuring millions of loans. I would call that a viable program. Whether it's viable in the long run will depend on their flexibility and how they manage themselves and their product offerings going forward."

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